Equitable Recoupment Entitled the State of California to Withhold Certain Post-Petition Payments Owed to the Debtor to Recover Pre-Petition Debt

By: Emily Santoro

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

In In re Gardens Regional Hospital and Medical Center, Inc., the debtor, a hospital and Medicaid provider, asserted that the State of California willfully violated the automatic stay by withholding post-petition payments and moved to compel turnover of the funds.[1] Under the Reimbursement Improvement Act of 2013, a hospital must pay Hospital Quality Assurance (HQA) fees in order to become a provider within the California Department of Healthcare Services (DHCS) Medi-Cal program.[2] After the debtor  stopped paying its HQA fees,[3] the issue was whether the principle of equitable recoupment permitted DHCS to withhold a percentage of supplemental HQA and Medi-Cal payments owed to the debtor, for the purpose of recovering the unpaid fees.[4] Throughout the course of this case, DCHS withheld a total of $4,306,426.18 in supplemental HQA and Medi-Cal fees from the debtor. Even after that withholding, the debtor still owed $2,550,667.39 in HQA fees.[5] Ultimately, the debtor’s motion to compel the State to turn over the withheld funds was denied.[6] The In re Gardens court held that the State was authorized to withhold a percentage of pre-petition payments owed to the debtor because their withholding was a permissible recoupment. According to the court, the withholding was a permissible recoupment because the debtor’s and State’s respective obligations arose from the same transaction.[7]

While the debtor in In re Gardens argued that DCHS’s withholding was a setoff, the court held otherwise, finding that DCHS was authorized to withhold the funds under the equitable doctrine of recoupment.[8] Setoff is an equitable right of a creditor to deduct a debt it owes to the debtor from a claim it has against the debtor arising out of a separate transaction, upgrading an unsecured claim to secured status.[9] The exercise of setoff rights is subject to the approval of the bankruptcy court and is limited to pre-petition claims.[10] On the other hand, recoupment is “an equitable doctrine that exempts a debt from the automatic stay when the debt is inextricably tied up in the post-petition claim.” [11] As it is not subject to the Bankruptcy Code, recoupment is not subject to approval by the bankruptcy court, and a creditor exercising recoupment rights is not required to take affirmative action to preserve their right to recoupment.[12] Therefore, creditors can recover across the petition date.[13] This advantage is balanced by the limitation that the claims or rights giving rise to the recoupment must arise from the same transaction or occurrence that gave rise to the liability the bankruptcy estate is seeking to be enforced.[14]

Within the context of recoupment, a transaction “may include a series of many occurrences, depending not so much upon the immediateness of their connection as upon their logical relationship.”[15] Courts have used the same definition of “transaction or occurrence” as is used to determine whether a counterclaim is compulsory – that a “logical relationship exists when the counterclaim arises from the same set of operative facts as the initial claim.”[16] Thus, in the recoupment context, “courts have permitted a variety of obligations to be recouped against each other, requiring only that the obligations be sufficiently interconnected so that it would be unjust to insist that one party fulfill its obligation without requiring the same of the other party.”[17]

The In re Gardens court adopted a broad interpretation of what constitutes a “transaction” in the recoupment context. The court found that the debtor’s obligation to pay HQA fees was related to DHCS’s obligation to make the supplemental HQA and Medi-Cal to the debtor because without the federal matching funds facilitated by the Reimbursement Improvement Act, which provided for the levy of HQA fees, DHCS would not have the revenue to make Supplemental HQA Payments to hospitals such as the debtor.[18] Therefore, the debtor’s HQA fee liability and entitlement to Medi-Cal payments arose out of the same transaction or occurrence as their obligation to pay HQA fees.[19]

In addition to adopting a broad definition of “transaction,” the In re Gardens court found that that the same transaction requirement is satisfied when corresponding liabilities arise under one contract.[20] Here, the debtor and creditor had a provider agreement that stated when the hospital fails to pay a HQA fee, DHCS could deduct the fee from any Medi-Cal payments owed to the hospital.[21] In re Gardens confirms that when there is a contract, such as a provider agreement, the issue is not enforceability, but whether the agreement created a relationship between the fee owed and the debtor’s entitlement to payments.[22] Here, had the debtor “not agreed to DHCS’s recoupment rights, the debtor would never have been eligible to perform the services entitling it to Medi-Cal payments.”[23] Therefore, the debtor’s debt is “inextricably tied up” in its claim for Medi-Cal payments and recoupment applies.[24]








[1] See In re Gardens Reg’l Hosp. and Med. Ctr., Inc. (In re Gardens), 569 B.R. 788 (Bankr. C.D. Cal. 2017).

[2] See id. at 791.

[3] See id. at 793; Cal. Welf. & Inst. Code § 14169.52(a) (stating that “[t]here shall be imposed on each general acute care hospital that is not an exempt facility a quality assurance fee[.]”).

[4] In re Gardens, 569 B.R. at 790.

[5] See id. at 793.

[6] See id. at 800.

[7] See id. at 790.

[8] See id. at 793.

[9] See 11 U.S.C. § 506(a)(1).

[10] See In re Gardens, 569 B.R. at 799.

[11] See In re TLC Hosp., Inc., 224 F.3d 1008, 1011 (9th Cir. 2000) (internal citations omitted).

[12] See id.

[13] See id.

[14] See In re TLC Hosp., Inc., 224 F.3d at 1011.

[15] See id. at 1012.

[16] See Aetna U.S. Healthcare, Inc. v. Madigan (In re Madigan), 240 B.R. 749, 775 (9th Cir. BAP 2001); F.R.C.P 13(a).

[17] See In re Madigan, 240 B.R. at 775; Lee v. Schweiker, 729 F.2d 870, 875 (3d Cir. 1984) (stating that while not necessary, that the same transaction requirement is satisfied when corresponding liabilities arise under one contract).

[18] See In re Gardens, 569 B.R. at 795.

[19] See id. at 800.

[20] See id. at 796-797.

[21] See id. at 796.

[22] See id. at 796-797.

[23] See id.

[24] See id.